Chapter 2B Flashcards
What is elasticity
Elasticity is a measure used to measure the degree of responsiveness of quantity demanded or quantity supplied of a good or service to a change in one of the determinants of demand or supply
The types of elasticity
- Price elasticity of demand
2. Price elasticity of supply
PED
measures the degree of responsiveness of the quantity demanded of a good to a change in its price, ceteris paribus
How is PED calculated
(Percentage change in quantity demanded)/ (Percentage change in price of the good
The sign of coefficient
Since the law of demand states that at any given period of time the quantity demanded of a good is inversely related to its price ceteris paribus, the sign for PED is -ve
Magnitude of coefficient
- 1PED>0
PED is relatively inelastic
- PED = 1
PED is unitary elastic
change in price leads to an equal proportional change in quantity demanded
4.PED = infinity
PED is perfect elastic
a change in price leads to an infinitely large effect n quantity demanded
- PED =0
PED is perfect inelastic
change in price leads to no change in quantity demanded
The graph of a good that has demand that is relatively price inelastic
graph shows a less than proportionate change in quantity demanded of good in response to a price change of good
shows that consumer responsiveness is to a small degree
The graph of a good that has demand that is relatively price elastic
graph shows a more than proportionate change in quantity demanded of good in response to a price change of good
shows that consumer responsiveness is to a large degree
Factors affecting price elasticity of demand
- Availability and closeness of substitutes
- Degree of necessity
- Proportion of income spent on product
- Time period considered
ADPT
Availability and closeness of substitutes
The greater the no.of substitutes the more price elastic demand is as consumers find it easier to switch to another good if prices of good increases
Degree of necessity
The greater the degree of necessity the demand for good is less price elastic because there are fewer alternatives people find it harder to give up on the good or switch
Proportion of income spent
The smaller the proportion of income spent on good, the less price elastic the demand of the good is. People don’t mind buying the good even if there is a price rise because it forms such a small proportion of their income ( almost insignificant). However for luxury good because they form a large proportion, a price drop leads to great consumer responsiveness
Time period considered
in short run = more price inelastic
in long run= more price elastic
- In the short run elasticity of demand tends to be more price inelastic due to lesser availability of substitutes and more price elastic in the future due to emergence of substitutes
- Commodity itself might be durable so changes in price will not lead to great response until all existing stock has been replaced (e.g : fridges)
- consumers need more time to change their habits
(e. g.: regular drinker/smoker) - Tech adv take time to be established
Changes in equilibrium of price inelastic
Relatively large rise in equilibrium price and relatively small fall in equilibrium quantity
Changes in equilibrium of price elastic
Relatively small rise in equilibrium price and relatively large fall in equilibrium quantity
Applications of PED for producers
- Pricing policies
2. Non pricing policies
Pricing policies
There is a relationship in price elasticity of demand and total revenue which will help in determining the price good to increase TR
Information a producer needs before making price adjustments
ADPT
Total revenue
refers to the total receipts received by producers from the sales of goods and services before the deduction of taxes or any other costs
PxQ
Profits+Cost incurred
TR if demand for good is relatively price inelastic
The loss/profit incurred from the change in Qd is less than proportionate to the increase/decrease in price hence revenue lost/gained from change in Qd is less than proportionate increase/decrease in price. Hence overall, total revenue increases/decreases
TR if demand for good is relatively price elastic
The loss/profit incurred from the change in Qd is more than proportionate to the increase/decrease in price hence revenue lost/gained from change in Qd is more than proportionate increase/decrease in price. Hence overall, total revenue decreases/increases
TR if demand for good is unitary price elastic
TR remains remains unchanged as change in price is equally proportionate to the change in Qd
Non pricing policies
- Marketing strategies
- Product innovation
- Advertising - Timing of decisions on pricing/marketing
Marketing strategies
Product innovation
makes demand more price inelastic by reducing alternatives , increasing the demand for it
Advertising
makes demand more price inelastic by raising its degree of necessity increasing demand
Timing of decisions on pricing/marketing
Short run
for goods with price inelastic demand, producer could increase price to increase TR
Long run
likely more price elastic demand
marketing strategies can be carried out to make product’s demand more inelastic so as to increase TR
Applications of PED for governments
- When considering what types of goods to tax to generate govt revenue.
- to consider amount of tax that is required to result in changes to consumer and or producer behaviour to reach a particular quantity
Price elasticity of supply
measures the degree of responsiveness of quantity supplied of a good to changes in its price ceteris paribus
aka producer responsiveness: how fast a producer can react to a price change
How is PES calculated
(Percentage Change in quantity supplied)/ (percentage change in price)
Sign of coefficient
PES is +ve
the law of supply states that at any given period quantity of supplied of good is directly related to the change of price ceteris paribus
Magnitude of coefficient
PES>1
PES elastic
PES <1
PES inelastic
PES = 1
PES unitary elastic
Change in price of good leads to an equal proportionate change in quantity supplied
PES=+infinity
PES perfect elastic
change in price leads to an infinitely large effect on quantity supplied
PES=0
PES perfect inelastic
change in price leads to no change in quantity supplied
Factors affecting PES
- Time
- Existance of spare capacity
- Availability and durability of stocks
- Length of production period
- Factor mobility
- Proportion of marginal cost of production as output changes
PLEAFT
Time
- Momentary period (now)
producer less likely to be able to respond to a price change as all factors of production are fixed and supply is restricted to the quantities actually available in the market at that point in time
(perfectly inelastic)
2.Short-run
more price elastic than 1.
Production is affected by at least one factor of production. Qs can increase to an extent in response to price change as some inputs can be increased while others remain fixed (go back to CELL)
3.Long-run
most price elastic
time period when all factors of production are variable
there will be sufficient time for all inputs to be increased for producers to increase their production capacity and new firms can enter market
Existence of spare capacity
easy to release spare stock into market if there is increased demand for it
presence of variable inputs such as labour and raw materials makes it possible to increase production quickly in short run
(price elastic)
Availability and durability of stocks
If stocks are durable and can be stored cheaply without loss of quality
(price elastic)
Length of production period
The shorter the time period for production to convert inputs into outputs
(price elastic) e.g: agricultural produce tend to be prince inelastic supply due to time needed to harvest
Factor mobility
The ease with which factors of production can be moved from one use to another will affect elasticity of supply the higher the factor mobility
(price elastic)
Proportion of marginal cost of production as output changes
if marginal cost of production increase sharply as output expands quantity supplied less responsive to price increases
Applications of PES to producers
The aim of producers is to increase price elasticity of supply so they can respond quickly to meet consumer needs in response to price changes in order to maximsise profits/ deter incurring losses which can be done through
- Increasing their spare capacity
- Improving supply change management
- Having a buffer stock scheme
IIH
Increasing their spare capacity
To increase production in short run by ensuring variable inputs such as labour and raw materials are readily available so as to respond to sudden demand increase
Improving their supply chain management
the process of planning implementing and controlling operations of supply chain as efficiently as possible Firms can work on better coordination and collaboration with channel partners(4)
(price elastic)
Having a buffer stock scheme
firms producing non perishable goods can have a buffer stock scheme. Goods are stored during low demand and in times of high demand released into the market
Application of PES to governments
1.understand impact of imposing taxes or price controls on certain goods
Limitations of the use of price elasticity concepts
- Assumption of ceteris paribus
- Reliability and accuracy of elasticity data
- Interactions between demand and supply
- Assumption of ceteris paribus
assuming that all other factors remain unchanged when analysing a specific concept
-the assumption that costs are held constant
e.g. In reality a decrease in price causes a more than proportionate change in quantity demanded/supplied
which necessitates increased production which causes production, and total costs may exceed the increase in total revenue
-other non price determinants not constant in the real world
(natural disasters, prolonged recessions , increased unemployment) affecting TR
these factors may determine whether the pricing strategies firms employ will maximise profits or not
- Reliability and accuracy of elasticity data
Reliability can be affected due to
- method of data collection
- how up to date the data is
- source of data
- inaccuracy in data (possibly due to rounding up of figure) resulting in wrong determination of elasticity and wrong approach used eventually leading to fall in TR
- Interactions between demand and supply
Factors other than specific non price determinant affecting demand and supply and elasticity .There might be more than one non price determinant factor affecting demand and supply.
